Investors should join forces to demand better sell-side research

A new survey draws attention to widespread flaws in sell-side research. But the advent of MiFID II may provide an opportunity for investors to push for change, write Steve Waygood and Anita Skipper.

Capital markets are the engines of economic growth. Efficient markets channel capital towards productive companies that generate wealth and create jobs over the long term. But in many cases markets do not function as they should. Investors do not have access to the information they need to accurately assess corporate performance and capital is being misallocated as a result.

Sell-side research is part of the problem. By providing investors with analysis and recommendations, the sell side has a significant influence on investment behaviour, and may ultimately determine the success or failure of companies. But sell-side research is overwhelmingly preoccupied with short-term financial metrics rather than long-term value creation, and largely dismissive of environmental, social and governance (ESG) issues. In addition, research is often inappropriately positive in tone, failing to deliver negative assessments of companies where necessary.

Aviva Investors commissioned a survey of 342 sell-side analysts to get a picture of the challenges and pressures that prevent them from producing in-depth research with a long-term focus. The findings are troubling, shedding light on how commercial conflicts of interest and skewed incentive structures interfere with objective appraisals of company performance.

Conflicts of interest

Many sell-side analysts are employed by investment banks, which intermediate between issuers and investors in capital markets. The reports produced by an analyst who works in the research department are often of interest to the investment bankers and investor-relations teams in the same organisation.

This environment breeds conflicts. Our findings show at least 90 per cent of mainstream analysts undertake additional caution when writing on topics sensitive to the bank they work for. And more than a third of mainstream analysts said, for the sake of their careers, they would avoid writing reports that may prove damaging to their employer’s commercial relationships.

Criticisms of a client or potential client of the bank are discouraged – albeit not always explicitly – whereas research that generates trading activity tends to be incentivised. As one sell-side analyst put it: “If your work is good for the bankers, you will get a good bonus." This encourages short-termism across the wider markets. Trading volumes increase as investors are persuaded to trade unnecessarily and the resulting turnover leads to shorter-term holdings.

Short-termism

Analysts’ short-term focus is partly a function of time constraints. Although they would like to write more in-depth research, mainstream analysts typically spend only 12 per cent of their time researching companies’ prospects beyond a one-year horizon, partly because they need to attend to other tasks such as client marketing and corporate roadshows. Analysts acknowledge these pressures interfere with the quality of their work: as many as 42 per cent of mainstream analysts agree sell-side research has a detrimental short-term focus.

Another problem is that many analysts neglect ESG factors, which typically affect companies over a longer time horizon. Some investment banks have started employing small teams of dedicated ESG analysts, which is a welcome development, but the majority continue to ignore sustainability issues. Only 16 per cent of mainstream analysts consider a company’s environmental impact as relevant to constructing an investment case, despite plentiful evidence that shows ESG matters are material drivers of long-term performance.

Time for change

The flaws in sell-side research are not merely a niche problem for financial-market professionals. Biased, incomplete research may lead to price targets and ratings that do not truly reflect a company’s long-term prospects, leading to a misallocation of capital and impeding the efficient functioning of markets. For capitalism to be sustainable, sustainable companies should be rewarded with a lower cost of capital. Poor quality sell-side research interferes with this mechanism.

To fix this broken system, participants from across the investment chain should come together to effect change. Companies should provide better data on long-term performance and ESG practices to enable analysts to incorporate this information into their reports. We also urge heads of research at investment banks to foster a culture that encourages and incentivises longer-term research, while resisting pressure from other parts of the business.

Regulators also have a role to play. In the UK, the Department for Business, Energy and Industrial Strategy should conduct a review of the practices within sell-side firms that influence analysts’ coverage. And the Financial Conduct Authority should stipulate that research reports must offer an outlook beyond a one-year horizon and demonstrate how material ESG considerations are integrated into analysts’ conclusions and ratings.

MiFID 2

The buy side can also do more to push for better standards. The new Markets in Financial Instruments Directive (MiFID II) could be transformational in this regard, giving investors an opportunity to reshape the nature of sell-side research.

Under the new directive, investment firms must pay for research directly, through dedicated accounts, rather than through commission-sharing agreements as was previously the case. If the buy side makes clear it expects, needs and values research that focuses on the long term and incorporates sustainability issues, then practice and habit will change and banks will respond. Analysts will be able to gain a competitive edge by providing the kind of nuanced, objective research investors want.

MiFID II is also expected to encourage a larger pool of research providers independent of investment banks. This should help catalyse more high-quality objective research, provided the buy-side are clear on their expectations and are willing to be more selective when allocating their research budgets.

Post MiFID II, investment banks, asset managers and regulators must work together to ensure sell-side research directs capital towards companies that are generating value over the long term. Better sell-side research will help retune the engines of the economy so that they drive sustainable growth for us all.

This article was originally published at www.responsible-investor.com.

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Important Information

Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at October 12, 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.

RA17/1316/31012018

Steve Waygood

Chief Responsible Investment Officer

Main responsibilities

Steve leads Aviva Investors’ Global Responsible Investment team. This team is responsible for integrating environmental social and corporate governance (ESG) issues across all asset classes and regions of the c£318bn of assets under management.

Experience and qualifications

Steve co-founded the Sustainable Stock Exchange initiative as well as the Corporate Sustainability Reporting Coalition, which is aiming to catalyse a UN Convention promoting enhanced corporate transparency and integrated reporting. His work became a case study in the Harvard Business School MBA in 2012.
Steve received the Leadership in Sustainability award from the Corporation of London in 2013, and he became an Ambassador for the International Integrated Reporting Council. He was a member of the UK Government delegation to the UN Rio+20 meeting in 2012, and a member of the European Commission’s expert groups on corporate governance and corporate responsibility. In 2011 he received the Yale Rising Star in Corporate Governance Award, and he was among the Financial News Top 100 Rising Stars in 2009.
Steve was on the board of the UK Sustainable Investment & Finance association (UKSIF) from 2003 to 2010, serving as its Chairman from 2006. He was also part of the expert group that wrote the United Nations Principles for Responsible Investment.
Steve is a member of the Chartered Financial Analyst institute, has a degree in Economics and a PhD in sustainable finance. He is a faculty member at the International Corporate Governance Network as well as the University of Cambridge Institute for Sustainability Leadership

Anita Skipper

Senior Analyst - Corporate Governance

Main responsibilities

Anita advises Aviva Investors on corporate governance and carries out engagement activities on their behalf together with their fund managers. Advice includes the development of Aviva Investors governance strategies and policies, opinions on remuneration consultations and on governance at individual companies. She works closely with Aviva Investors' fund managers.

Experience and qualifications

Anita's governance experience began in 1993 when she was appointed Head of Corporate Governance at Norwich Union Investment Management, soon after the publication of the Cadbury Code. Since then she has been influential in the development of corporate governance in the UK and beyond. Anita is a member of the Investment Association’s Corporate Governance Committee and other industry bodies She was on the board of governors of the International Corporate Governance Network (ICGN) and continues to participate on a number of global governance committees.
In 2011, Anita was voted by Financial News as the most influential woman in asset management.
Anita has a law degree from Nottingham University.